The market still does not understand what inflation-targeting is: Jahangir Aziz, JPMorgan

 There are conflicting signals on Indian economy — one day, industrial output grows, the next day, the core sector shrinks. One month, inflation surges, and, in the next, it falls. Then there is inflation-targeting by the government. How does one connect these moving parts? Jahangir Aziz, head of emerging market research at JPMorgan, explains them to MC Govardhana Rangan and Saloni Shukla. Edited excerpts:

There’s leadership change at the RBI. Monetary economists are happy with him (new governor Urjit Patel) as he comes with a body of work, but traders feel he is too rigid. How do you see him?

I think he is the natural successor to Raghu (previous governor Raghuram Rajan) and, given the fact that he is one of the architects of the inflation-targeting framework, my guess is he is personally invested in that project.

Therefore, without even going into what happens to data, my guess is he will at least be honest and invested in that framework and, therefore, at least that part of the monetary policy wouldn’t see very many changes. What I think is the problem is that the market still doesn’t understand what inflation-targeting is and that is the biggest gap between what RBI might be trying to do and how the market is interpreting its moves.

How should the market understand inflation-targeting?

The RBI, since its inception, has always reacted to inflation, but inflation-targeting has nothing to do with a central bank reacting to it. Under the current MoU, it means that the RBI is accountable for the inflation rate. It doesn’t matter whether the monsoon is good or bad, whether the government maintains or doesn’t maintain its fiscal deficit. The RBI is accountable for the 4% inflation rate in 2018, that’s it. If it misses the target, it has to come up not only with a reason as to why it missed it, but take remedial measures, that’s in the MoU, which is very different from saying I am going to react to inflation.

What does that mean?

The fact that food inflation has gone down and will go down further does not mean it has opened up the space for monetary policy easing. Space will open up for monetary policy easing if the MPC (Monetary Policy Committee) decides that, given where we are today, 12-18 months down the road, we are comfortable that the 4% target will be met comfortably.

That means more focus on forecast than actual data.

That’s correct and that means they have to forecast growth, what is happening to the global economy. They have to forecast what will happen to the rupee and what will happen to global interest rates. So that’s the way they have to form policies. I think the distinction of being accountable for a number and just reacting to the number is very different and the market still doesn’t understand that.

Whenever there’s a drop in inflation reading, there’s a demand for a rate cut…

Unless that reading is telling me that 12 months ahead that inflation print, which is my target, also changes. If the drop or the rise in inflation rate in the month of August has no information about my March 2018 target, then I don’t react. That’s what inflation targeters do.

With food inflation being structural, shouldn’t we take CPI numbers with a pinch of salt?

That is not in the MoU. That boat has sailed. The MoU does not say ‘x’ food inflation, it says headline inflation and it is very specific. It says new series CPI headline inflation. Till that MoU changes, it is cast in stone.

What other tools do the monetary authorities have to meet that target? Former Governor Rajan used to say interest rate is a blunt tool, but that’s the only one they have.

We all know it is a blunt tool. But it’s a tool that has worked and they have the interest rate tool and the transmission mechanism. Both of them are also controlled, to a large extent, by the regulator. There are reasons as to why it hasn’t transmitted and policy changes can be made to change that monetary transmission.

The fact that transmission isn’t working is a worldwide phenomenon. You have had QE (quantitative easing) in the United States for eight years, look at what’s happened to bank credit, nothing much. Only now has bank credit started to limp up. BoJ (Bank of Japan) has been trying for over three decades to get inflation up by massively increasing money supply, and there are reasons why it doesn’t get transmitted. My point is that the regulator has tools to affect interest rates, transmission and obviously it has tools that affect liquidity measures which also help transmission. So I would say it has tools.

You spoke about the importance of inflation forecast. The RBI, in its annual report, admits to the difficulty of forecasting. How do you see them moving ahead?

I would suggest that those are the questions they should have asked themselves before they signed the MoU. If you are going to sign on a piece of document that says I, the Reserve Bank of India, shall be accountable for inflation-target, then before signing that document, they should have thought if they are capable of delivering inflation target as a framework, do they have the requisite tools, do they have the requisite research capabilities and do they have the data to execute that.

Has RBI fallen into a trap?

No. I think you can still implement inflation-targeting, but you can say, ‘Yeah, sure, I do not know the exact impact of the pay commission hike on inflation, but I broadly understand the direction it will take.’ Will it take inflation higher or lower and if I am looking at a 5% target for six months and 4% target for 18 months from now, and I think this particular action is going to raise rather than lower inflation, then that should inform your decision-making. The fact that I cannot pin point what the inflation rate is going to be does not detract me not from doing inflationtargeting.

There is a school that believes RBI must not look at food inflation since it cannot anyway be controlled by interest rates?

People who say you can’t control inflation because inflation is due to food, monetary policy has nothing to do with that, I am not saying it’s not a legitimate argument. I completely disagree with it, but it’s still legitimate. But those are things that should have been discussed when the Srikrishna report was put up. Food inflation is 30-40% of the CPI basket, what about the rest of it? That is under monetary policy. And I would argue that a significant portion of that 40% has very little to do with farm prices. It is the price that is added from the farm gate to the point where the consumer is buying it. And that portion is almost entirely services. I can control that.

There is a lot of talk of this 8% growth and achieving it is the goal…

Look, we have made this into an aspirational thing. These numbers aren’t really meaningful in the sense that at the end of the day you have to make sure that the economy is in a state in which people are getting jobs and inflation is under control. Unfortunately, we don’t have a measure of people getting jobs, but we can look around and feel that whether or not the economy is creating jobs and is inflation under control. If I go and tell my mother-in-law that inflation is under 5.5%, she will probably physically assault me. But the question is, do we feel this economy is growing up, are people getting jobs or is inflation under control, do we have growth, do we have macroeconomic stability, whether it is 8-10% who knows?